Where Now on Interest Rates?

Many investors watch the daily close of major stock indexes as an indicator as to where market winds are blowing. It also pays to watch the direction of interest rates as a portent of trends.

 At December’s end, 2013, the benchmark 10-year Treasury note closed above the psychologically key level of 3%, following a May, 2013 low of 1.63%. Investors took the surge in interest rates as a sign that global growth and inflation would heat up. Approaching summer 2014, expectations have softened, as have interest rates and markets. Key indexes have dropped below recent highs as big money movers took profits assuming lower growth, retreating to more defensive positions.

 Moves to safety depress interest rates. On May 15, 2014, the 10-year Treasury yield fell to 2.472% in intra-day trading, the lowest level since October 23, 2013. Investors have not eschewed stocks in general; they have hammered riskier lofty-valuation sectors such as technology and biotech. Small capitalization shares that depend on fast economic growth have sold off. Early this year some pundits were yawning relative to “staid old utility shares” and other dividend plays. So far, the S&P 500 utility sector is leading the parade for 2014, up 10%.

 Forecasts of rising inflation have not panned out short-run. Inflation globally still is falling, with a slight uptick in U.S. numbers. Growth in the Euro Zone remains sluggish, restraining inflationary-pressures, midst relief that the basket case PIIGS (Portugal, Italy, Ireland, Greece and Spain) did not implode in the 2008-2009 credit crisis. Unemployment across Europe remains well above U.S. averages as economists worry about whiffs of deflation. As of April 2014, U. S. Core CPI was running at an annualized rate of 1.8%; All Items, +2.0%.

 With all items inflation at 2%, for an investor at a 20% average federal and local tax rate, the breakeven investment return net of taxes and inflation is (2/.80=) 2.5%. With safe money yields at low levels, and with Federal Reserve Bank head Janet Yellen pledging low interest rates for the foreseeable future, investors and retirees will continue to subsidize easy money policies with foregone real returns. The average bank money market fund yields 0.40% (40 basis points or 40/100s of 1%); a 5-year CD, 1.39%.

 If you are retired and taking 4% of your portfolio annually to live on, with inflation at 2% and taxes at a 20% average rate, your breakeven yield becomes (4+2=6/.80=) 7.5%. Investors and financial advisors are challenged in crafting risk/reward scenarios that will allow investors to hold their own or book net real profits while sleeping at night sans an Ambien-induced coma.

 Dr. Don Ratajczak, leading economic forecaster and Professor Emeritus of Economics, Georgia State University, notes that Federal Reserve “price controls” are slowly coming off. Speaking to financial planners at a symposium in Atlanta, May 15, 2014, he thinks it may take 3 years for the 10-year rate to reach equilibrium of around 3.25%-4%, and 5 years to get to 5%, closer to the long-term average. Between 1962 and current, the 10-year note averaged 6.57%. The record high was 15.84% in September 1981 following the “stagflationary” 1970s; the record low, 1.40% in July, 2012. We are a long way from an inflationary blow off, notwithstanding the hysterics of some gloom, doom, and bust touts.

 A jump in tax receipts has governments borrowing less, for the time being. Mortgage borrowing is hardly growing at all, notes Dr. Don. People are paying cash and young people, burdened by college debt and tepid job prospects, are delaying marriage and family formation while living with parents or doubling up in apartments. Increased U.S. energy production means less imports. All in all, less borrowing from the rest of the world. Also, foreign bonds are paying little more than American paper, if that, so U.S. Treasuries remain an attractive haven when global investors get the willies over instability  (the “Putin put”) or uncertain investment prospects.

 Interest rates are likely to remain constrained. For asset allocators, that bodes positives and negatives as various asset classes are evaluated.

 Walker Capital Management, LLC, Lewis Walker is President of Walker Capital Management, LLC.  Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC.